Friday, July 13, 2012

Lessons from the U.S. Shale Revolution: It Wasn't from Gov't Planners, but Private Entrepreneurs

"One of the few bright patches in the Obama economy is the booming
production of shale gas and, increasingly, oil. The U.S. ranked 159th in
GDP growth last year. But in natural gas production, it's now No. 1.

How did that happen? Partly it's the luck of geology, though plenty
of other countries have abundant shale resources. Partly, too, it's
American technological leadership in developing hydraulic fracturing
(fracking) and horizontal drilling. But those techniques are now widely
understood the world over.

What gave the U.S. its edge is that the early development risks were
largely borne by small-time entrepreneurs, drilling a lot of dry holes
on private land. These "wildcat" developers were gradually able to buy
up oil, gas and mineral leases from private owners while gathering
enough geological data to bring in commercial producers.

Now compare this to Europe, which sits on an estimated 639 trillion
cubic feet of shale gas yet remains heavily dependent on Russian
imports. The governments of France and Bulgaria have banned fracking on
dubious safety grounds, with nary any pushback from their publics. That
might not be the case if French farmers, for example, were able to
profit from the riches underneath their terroir.

Countries such as Poland and Great Britain are willing to develop
their shale potential. Yet in both places the absence of private mineral
rights has delayed exploration and production.

In time, perhaps even the French will recognize their lost opportunity
and lift their ban on fracking. But the deeper lesson is that this is a
revolution that came about not through government planning or foresight,
but through a combination of individual risk-taking and private
property. Europeans could benefit by doing more to broaden the latitude
for both."

Since when is the capital destruction by the shale gas producers a good thing for investors or the country? Why is it that the journalists and academics have yet to question a single bubble over the past few decades? The WSJ was cheering the tech bubble in the 1990s and the housing bubble in the 2000s. Today it is cheering the shale gas bubble even though the producers have admitted to massive losses and are busy reducing drilling activity.

@VagelVHow can you blanketly claim "capital destruction" here? Sure, some ventures in this shale play will not work out. Some may. Some offshoot technologies and industries may arise. And to imply the "tech bubble" was a total loss of capital how do you explain Google, Amazon, etc? The world has benefitted greatly from the capital put forth in the tech industry.

How can you blanketly claim "capital destruction" here? Sure, some ventures in this shale play will not work out. Some may. Some offshoot technologies and industries may arise. And to imply the "tech bubble" was a total loss of capital how do you explain Google, Amazon, etc? The world has benefitted greatly from the capital put forth in the tech industry.

I can claim it because the industry produced gas at a price that was well below cost and had to finance its activities by borrowing and diluting existing shareholders.

Google and Amazon have nothing to do with this debate because neither company based its business model on constant negative cash flows and losses. The problem with shale gas is that it cannot produce a positive return on the energy invested outside of certain core areas. That makes it a destroyer of capital. (The argument is similar for shale oil.)

And when people begin to mix up shale oil with oil shale they really go off the deep end and make claims that have absolutely no basis in reality even in the 'core' areas. Yet, the optimists keep on spinning the story if they were the same thing and keep forgetting to look at the balance sheets and cash flow statements of the producers.

So true but then again in the 'free market' environment can a real monopoly ever exist without some forces external to the free market to aid the development of a monopoly?

Yes, a monopoly could develop. But the monopoly model in real life is very different from the one taught in Econ classes. In class they teach that supply shrinks & prices skyrocket allowing the monopolist to earn "excess profits". In reality one gains a monopoly by selling large quantities of well made products at a price your competitor cannot afford to sell at. So, a monopoly that develops in a free market is nothing to worry about and is a positive for society.

"I can claim it because the industry produced gas at a price that was well below cost and had to finance its activities by borrowing and diluting existing shareholders."

So does this imply that oil companies got hosed? I thought these guys were "evil billionairs". I'm not able to follow how gas prices had to do with the tech bubble yet Amazon and google has nothing to do with it.

On another thought, how did it cause gas to sell below cost? what forced them to sell gas at a loss?

And ya, its sounds like people are crossing their fingers they strike their wells in a "core area". No shit. That's the risk. There's no guarantee of any sort that dropping millions on a well is going to pay off.

I understand your pessimism of this so called "bubble" if your worried that Obama writes them off too (assuming he steals a second term). other than that, big whoop. The Dakota peoples are pigs rollin in shit right now.

Yes, a monopoly could develop. But the monopoly model in real life is very different from the one taught in Econ classes. In class they teach that supply shrinks & prices skyrocket allowing the monopolist to earn "excess profits". In reality one gains a monopoly by selling large quantities of well made products at a price your competitor cannot afford to sell at. So, a monopoly that develops in a free market is nothing to worry about and is a positive for society.

You are going to the wrong economics classes. The only monopolies to be feared are those that are granted by governments, not those won in the marketplace.

I understand that if you were running an oil company you would not be drilling in the Bakken..but you must agree that investing there, whether companies fail or succeed, is an important part of the market discovery process and creative destruction. Do you agree or disagree with that?

So does this imply that oil companies got hosed? I thought these guys were "evil billionairs". I'm not able to follow how gas prices had to do with the tech bubble yet Amazon and google has nothing to do with it.

Most of the oil in the world comes from conventional sources that are quite profitable. And oil companies are only evil in the eyes of political operatives on the left or right and the fools who believe their misrepresentations.

My point is that Amazon and Google can make profit. So can conventional oil companies. The shale gas players that Mark was hyping were unable to do so because they sold most of their production at below cost. That may be fine for consumers but not for investors.

Lack of storage. If you have to produce because stopping means writing down your leases and going bankrupt the prudent thing to do is to keep adding debt and selling gas at a loss for as long as possible. If the public buys it you can reposition yourself as a 'shale liquids' company and issue new equities as you add more debt and do it again until reality overtakes you.

And ya, its sounds like people are crossing their fingers they strike their wells in a "core area". No shit. That's the risk. There's no guarantee of any sort that dropping millions on a well is going to pay off.

Companies know where the core areas are and could be profitable working them. But they can't grow as big if they stick to such small fields so they went all out and leased unproductive formations. If you are the CEO and can get another $80 million or so before you go bust it certainly beats working another 30 years and only earning around $3-$5 million during that time.

I understand your pessimism of this so called "bubble" if your worried that Obama writes them off too (assuming he steals a second term). other than that, big whoop. The Dakota peoples are pigs rollin in shit right now.

I am not worried about the people who have gotten rich by getting decent jobs when the rest of the country is hurting. The trouble for them will come after the bubble ends, particularly if they are counting on the same income level and are leveraged.

You are going to the wrong economics classes. The only monopolies to be feared are those that are granted by governments, not those won in the marketplace.

Did you read my post? I said that a monopoly that occurs in a free market is nothing to worry about and is good for society. My posted debunked the idea that free market monopolies are a problem. Of course I agree that only government monopolies are worrisome.

You are going to the wrong economics classes. The only monopolies to be feared are those that are granted by governments, not those won in the marketplace.

Did you read my post? I said that a monopoly that occurs in a free market is nothing to worry about and is good for society. My posted debunked the idea that free market monopolies are a problem. Of course I agree that only government monopolies are worrisome.

"In reality one gains a monopoly by selling large quantities of well made products at a price your competitor cannot afford to sell at. So, a monopoly that develops in a free market is nothing to worry about and is a positive for society"...

Well you know tradetheleaders up until about three and half years ago that was my opinion more or less also...

I understand that if you were running an oil company you would not be drilling in the Bakken..

First, that is not what I am saying. What I expect is that the company would stick only to the core areas and would not blindly go after leases that make no sense.

Second, if my goal was personal wealth I see no problem going after as big an area as possible and using debt and asset sales to stay afloat for a few years. I would use the general assumptions that make it possible to hide losses by underestimating depreciation costs, use the 6:1 energy conversion ratio to overstate equivalent reserves and make the company as attractive as possible for a conventional producer needing to hide a reserve depletion problem for a while.

All that would be perfectly legal and would comply with industry practices. If I were good and lucky I could sell the company to a conventional player, preferably a foreign one, and would pocket a compensation package that would not be possible in three lifetimes if I ran the company according to what reality dictated. My investors would love me because I made them rich.

My proceeds would go towards coal, uranium, unconventional producers that made economic sense in a high priced environment, and silver and agricultural stocks for diversity.

...but you must agree that investing there, whether companies fail or succeed, is an important part of the market discovery process and creative destruction. Do you agree or disagree with that?

I disagree with it. We already know that gas is not profitable under $7.50 and the EROEI is too low to bother at this time. Horizontal drilling and fracking are not new processes and while they are useful they will ensure that the back end of Hubbert's Peak is a lot steeper than we are used to. Rather than wasting money on mature but uneconomic ventures that will not make any sense I would look towards investing in hew ways to capture the energy in methane hydrates or try to develop new forms of nuclear power generation.

I disagree with it. We already know that gas is not profitable under $7.50 and the EROEI is too low to bother at this time. Horizontal drilling and fracking are not new processes and while they are useful they will ensure that the back end of Hubbert's Peak is a lot steeper than we are used to. Rather than wasting money on mature but uneconomic ventures that will not make any sense I would look towards investing in hew ways to capture the energy in methane hydrates or try to develop new forms of nuclear power generation.

So what is supposed to be done here? Do you advocate some kind of government rules against this action - or do you simply think the companies are mismanaged and should be allowed to suffer their own fates?

So what is supposed to be done here? Do you advocate some kind of government rules against this action - or do you simply think the companies are mismanaged and should be allowed to suffer their own fates?

No government action is necessary. The way I see it the shale companies are making it very clear that things are not the way they are portrayed as and have shown that they can't be self financing and can't survive without adding more debt. My argument is that they should be free to do what they do and investors should be free to chase their dreams.

My problem is with the easy money policies that make this possible. I find it interesting that people who keep harping against 'monopolies' that may be created in a very competitive environment where the consumer is king are so silent on the issue of a government granted monopoly on the creation of money and credit by the Federal Reserve System, which has been behind every major bubble in our lifetimes. Get rid of the legal tender laws and let private companies get into the business of money creation and you will have a much more disciplined system in which this type of speculation cannot take place for very long.

If you don't drill outside of so called "core areas" you will never find new core areas. There are new fields being found often in the Bakken that are now major producers.

Who says that we have not drilled outside of those areas? We have drilled. And we have figured out that the formations are not a good source of tight oil and gas even with horizontal drilling because the energy return is negative. This does not mean that you can't discover a small field that is perfectly good and economic. But you can't use the returns from such discoveries to justify destroying capital on producing oil in the rest of the formation.

Keep in mind that for shale production there is no NI 43-101 equivalent that would allow investors to reduce many of the risks inherent in the process. Sadly, the SEC allows far too many loopholes that allow companies to overestimate the ultimate recovery and by doing so reduce depreciation costs. But even though such manipulation is possible the cash flows and debt levels provide us with enough information to tell us what is going on.

Let me note here that I expect that many of the optimists who have been posting all kinds of pro-shale messages will try to claim that the companies lied. Actually, they did not. If I can figure out the fact that shale is a bubble so can anyone who can think clearly and has the ability to read carefully and to pay attention at conference calls.

Why is it that the journalists and academics have yet to question a single bubble over the past few decades?

The tech and housing bubbles were caused by easy credit and cheap money through FED manipulated money supplies. Is that what's going on in Bakken? Are there wells there because of artificially cheap money driven by stupid government policy?

The tech and housing bubbles were caused by easy credit and cheap money through FED manipulated money supplies. Is that what's going on in Bakken? Are there wells there because of artificially cheap money driven by stupid government policy?

They are there because of easy money policies and the availability of credit. Why else would companies that have yet to show positive cash flow after six or seven years have access to more borrowing even as their balance sheets show an explosion of debt?